The key tenet of why US Treasuries, gilts (UK government bonds) and Bunds (German government bonds) are considered among the safest assets, besides cash, is that the governments that issue them are unlikely to default.
That means dividends can evaporate and debtors are left with worthless bits of paper. But high-quality government bonds are also better than equities in another way: they tend to exhibit less volatility, particularly over shorter time periods, which was confirmed in a recent Allianz Global Investor report, Equities – the “new safe option” for portfolios?
ROLLER-COASTER RIDE
The report’s authors found that the biggest fluctuations in any one year for equities ranged from a 38% fall in to a 67% rise in 1862 when looking over a 213-year period. With government bonds, the ride was far less gut-wrenching, with the largest loss recorded being 22% in 1864 and a largest gain of 35% in. Certainly there is tremendous value in having the almost guaranteed income provided by government bonds with less short-term volatility. The investor in government bonds can sleep better at night.
But are they potentially paying too high a price for this security? The report noted that over the last two centuries, there has been tremendous economic growth and value creation across many countries. Equities allow investors to participate in that growth, while government bonds, which pay a fixed interest rate and redeem at a specified value, don’t. Indeed, looking back over decades, stocks have tended to outperform government bonds.
In the 10 years to, the Barclays annual Equity Gilt Study found US shares produced an average annual return of 5.8% compared with 5% for US Treasuries. Over 20 years it was 6% versus 5.9%, and for 50 years it was 5.7% and 3.2%, respectively. However, the authors of the Barclays report believe the higher risk premium attributed to equities is in line with financial theory. Equities are subject to more uncertainties than government bonds, they argue. One factor they observed as “the most striking feature” is the change in the volatility of returns between the two asset classes, which actually diminishes when measured over decades.
DEFAULT BY STEALTH
However, is the income stream and principal on government bonds really that safe? The biggest problem faced by owners of government bonds is default by stealth, especially over the long term. This occurs due to inflation as the purchasing power of the income and the principal are slowly but surely eroded by inflation. And there is always a temptation for heavily indebted governments to resort to creating inflation. Even a modest inflation rate of 2% – a target for a number of central banks – will reduce the purchasing power of €1,000 today to €820 in 10 years and €673 over 20 years.
The Allianz report remarks that over time, equities tend to protect the purchasing power of an investment far better than government bonds; well-positioned companies can raise their prices and potentially keep up with inflation. But where equities really trump bonds over very long periods is their ability to increase dividend payments – in a sense creating a form of hedge against inflation.
Using an extreme example to illustrate the point – the Barclays study says £100 invested in the UK stock market at the end of 1899, without dividend reinvestment, would have been worth £168. Reinvesting them would have produced a staggering £24,184. The effect upon gilts is less in absolute terms, with the ratio of the reinvested to non-reinvested portfolio exceeding 400 in real terms.
DO IT LIKE WARREN
Legendary investor Warren Buffett embodies many key findings of the Allianz and Barclays reports. After all, his ideal holding period for a stock is “forever”. Buffett dismisses volatility as a risk when investing in high-quality companies; he is far more concerned about a stock increasing the purchasing power of an investor’s money over time. But he does believe in not overpaying for those companies. He also says investing in government bonds over the long term is risky given the corrosive effects of inflation.
Although he regularly trumpets the benefits of stocks, very few are able to meet Buffett’s selection criteria. His most important characteristic is that they possess “deep moats,” or strong long-term competitive advantages. This provides pricing power, which means growing profits and an ability to sustain margins during periods of inflation or recession.
Matched with a strong balance sheet, these characteristics translate into consistently high returns on equity and a high level of retained earnings. If management is shareholder-friendly, that means share buy-backs and rising dividends. He also likes companies that don’t have to keep investing heavily to maintain their competitive advantage, which is a key weakness for tech firms.
Over time, equities tend to protect the purchasing power of an investment far better than government bonds
JOHNNIE WALKER VERSUS GOVERNMENT BONDS
Johnnie Walker is nearly 200 years old and is the world’s top-selling whisky. It has a high chance of still being around in 50 or even 100 years from now. It’s difficult to say that with the same level of confidence about Google, Apple, Microsoft or Facebook. Despite their commanding market positions, all are vulnerable to technological change. It’s no surprise that there are few tech stocks in Buffett’s portfolio, with IBM being an almost singular exception.
Brands such as Johnnie Walker, which have a strong consumer following, are likely to deliver better returns to their owners than government bonds. Taking into account the pros and cons of bonds and equities, the authors of the Allianz report believe the latter could most benefit investors looking to preserve and grow their wealth over the long term, in large part because of the effects of inflation. Going forward, they think the risks for bonds will probably increase rather than reduce. Interest rates are likely to rise from very low levels, leading to losses on the traded values of bonds. They feel that the historical success of shares is set to continue, with their long-term risk premiums still looking attractive compared with bonds and cash.
TO HAVE AND TO HOLD?
Between now and, Allianz Global Investors forecasts that US economic growth could average 2.3% a year, with Europe managing 1.7% and emerging markets 4%. Estimated annual inflation in these regions over the same period is possibly 2.5%, 2% and 3%, respectively, which should see nominal earnings growth of 4% a year in industrialized countries and 8% in emerging markets.
Allianz also sees scope for higher dividend payouts, with company-dividend-to- corporate-earnings ratios standing at 36% in the United States and 53% in Europe. Not only are company earnings potentially set to increase, but so are cash flows. Though government bonds certainly have a role to play in investment portfolios, holding them over the long term does come at a price. Essentially it comes down to the cost of missing out on participating in economic growth and being vulnerable to the vagaries of inflation.
